Wednesday, November 16, 2016

Generic Republicans and the Economy: The Limits

So, let us suppose that Republicans really do manage to revive the economy by financing operations by printing money. Isn't that supposed to be one of those things that can't keep on forever? Isn't it supposed to cause out-of-control inflation? Well, yes and no. Certainly, it has done just that many times in the past. On the other hand, funny things start happening when the economy is at the zero lower bound (the place at which cutting short-term interest rates to zero cannot raise the economy to capacity). Japan, at the zero lower bound, has been financing operations by printing money for two decades now, and hasn't even been able to escape deflation. Still, that appears to be largely because the leadership has kept losing its nerve and refusing to keep deficits large enough for long enough. The Republican Party inspires no such fears. So, assuming it keeps financing operations by printing money long enough to get the slack out of the economy and raise inflation to around 4-5%, that approach will not be able to continue forever. I can see several ways it can come to an end.

Premature tightening. The Fed might lose its nerve and tighten too soon, sending the economy into recession and we may find ourselves once again at the zero lower bound, with the Fed having great difficulty reviving the economy. Fortunately, the Republicans will be ready to offer plenty of fiscal support. Don't lose your nerve next time, guys!

Well-timed tightening. The Fed may get it just right. It may wait until inflation starts getting over 5%, then tighten. This will induce a recession,but as soon as inflation falls, the Fed can ease up and the economy will rebound. In this case, recession will take longer to materialize and recovery will be easier. If the Fed is feeling hackish, it may manage to time recovery to coincide with election season and offer maximum benefit to Republican. Still, they will deserve it for a well-executed maneuver. On the other hand, this scenario calls for a level of technocratic skill that Republicans not only generally lack, but are ideologically opposed to, so I am inclined to consider it unlikely.

A soaring dollar and an asset bubble. US interest rise while everyone else's remain flat. Foreign investors flock to the US. The dollar soars. This will no doubt be a source of nationalistic pride, but it will also flood the country with cheap imports and price out our exports -- exactly the opposite of what Trump was campaigning to do. This will probably not upset too many people so long as the US economy appears to be soaring. On the plus side, the US could help pull the world economy out of its rut. On the minus side, the world economy could drag the US down. But the really serious problem is that combining a vast influx of foreign capital with a relaxation of financial regulation (more on that later) is made to order for another bubble and bust. Then again, this scenario could be avoided if right wing populists in other countries see the US economy surging from reckless spending and monetary expansion and do the same.

Too much inflation. We all know what normally happens with countries finance deficits by printing money -- inflation. Japan has avoided that fate because it is at the zero lower bound. We are beginning to move away from it, at least, the Fed has raised short-term rates above zero without tanking the economy. Once we move away from the zero lower bound, our ability to finance deficits by printing money will start to generate inflation. To an extent (Krugman estimates until inflation reaches 4-5%) this will be a healthy development. But what after that? What if the Republicans find a Fed sufficiently hackish to keep expanding in order to expand Republican fortunes? Inflation will continue to escalate. There is another term for continuing such a policy -- macroeconomic populism. It has long been practices by left-wing populists in Latin American countries, and has invariably led to hyperinflation. Rates have hit triple, quadruple, and even quintuple digits. I am not worried about such a thing happening here. The Fed has proven that it can curb inflation by tightening. Well short of that point, people will be prepared to tolerate a short-term recession rather than allow any more inflation.

When will that time come? I have no idea if it will even get to that. But it seems a safe bet that no one will much mind 4-5% inflation. I have no idea how high above that it can go before people get upset. 6-7%? 8-9%? I am reasonable confident that if inflation ever reaches double digits, the pressure will grow to do something about it, and the Fed will. And anyhow, all this is purely speculative.

But even assuming that we get the macro right and that the economy returns to a macroeconomic normal, that addresses only the short to medium run. Deficits of the type Republicans are proposing cannot be sustainable in the long run for another reason.

The growing burden of debt service

Nothing described above is really any more than just the normal business cycle, which won't go away just because Republicans are in charge. To understand what deficits are or are not sustainable requires going beyond the simple assumption that all deficits are bad to a more complex understanding (invariably derided by people who see complex understandings as mere hypocrisy) that not all deficits are alike. This requires understanding the distinction between temporary deficits and permanent deficits, cyclical deficits and structural deficits, and primary deficits and fiscal deficits.

Temporary versus permanent deficits: This one is the simplest. A deficit caused by a short-term measure like a temporary tax break or a one-time expenditure is temporary and need not affect the long-run sustainability of the budget. A deficit caused by a permanent tax cut or implementation of a new program does affect the long-term balance of the budget and, if not made sustainable, can lead to serious problems down the road. For instance, for all the freak-out the Obama stimulus generated, most of it consisted of one-time expenditures which would expire on their own and not blow up the budget over the long run. Obamacare, by contrast, is a program that is intended to be permanent and must therefore be financed, either by tax increases, or by permanent spending cuts elsewhere. Likewise, Trump's proposed infrastructural program is a temporary measure that will expire on its own. Proposed tax cuts, on the other hand, are permanent and have ample opportunity to blow up the budget.

Cyclical versus structural deficits: This distinction is best illustrated by a graph:

A few things are significant here. One is that outlays and revenues tend to move in opposite directions. That is the business cycle at work. During recessions, revenues drop and expenditures on unemployment insurance and the like rise. But these deficits are not worrisome because they will be erased when the economy recovers. Another is that the projected expenditures and revenues are a lot smoother than the actual ones. That is because actual revenues and expenditures reflect these cyclical ups and downs, while projected ones do not.

Another point is what it shows about the Republican supply side argument that tax cuts ultimately raise revenues. Ronald Reagan's tax cuts took place in 1981, in a severe recession. That year shows a sharp drop in revenue, partly as a result of the tax cuts, and partly because of the recession. Although Reagan admirers like to boast that tax revenues increased, as we can see, they remained unchanged as a share of the gross domestic product (GDP). Bill Clinton's tax increases took place in 1993, a year in which the US was starting to come out of a recession, but recovery was looking very slow. Republicans screamed bloody murder, but revenues did increase, partly from the tax increases, and partly from general economic recovery. At the peak of the business cycle, the US budget actually went into surplus. George W. Bush cut taxes in 2001, also in a recession. Revenue fell, partly from the tax cuts and partly from the recession. With recovery, revenues recovered, shrinking the gap to well below average at the peak of the business cycle. The the financial crisis of 2008 broke out, and deficits skyrocketed to unprecedented heights. The full scope of the deficit led to panic, but spending fell and revenue improved over time. The graph below is illustrative:

This graph shows deficits as a share of GDP and how they have ebbed and flowed with economic ups and downs. Clearly the deficit following the financial crisis was larger than anything we have seen since WWII, even higher than our deficits in the 1930's. It has fallen considerably since then. But as we approach the peak of the business cycle, the deficit remains 2.5% of GDP, an abnormally large deficit for this stage. This amount is clearly structural; it will not be erased (at least not much of it) with further economic recovery, and it will rise with the next recession. So, yes, this is a problem.

Consider, then what the Republicans intend to do about it. They intend to make immense tax cuts, a major military buildup and (at least per Trump) a large infrastructural building. Then compare to what we have now. The Congressional Budget Office (CBO) estimates 2016 expenditures at $3.9 trillion and revenues at $3.3 trillion, for a deficit of approximately $600 billion as we near the peak of the business cycle, or a little over 15% of the budget. This is worrisome. Now, what do the Republicans want to do? Trump's tax cuts are estimated to reduce revenues by $5 trillion over ten years or (grumble, grumble about how I hate that "over ten years" formulation) about $500 billion per year. That would raise the deficit to $1.1 trillion per year. Add to that his infrastructural plan for $1 trillion over ten years (grumble, grumble), or $100 billion per year and you raise the deficit to $1.2 trillion, or about 30% of the budget. Recall just how intense the alarm was in 2009 when Obama took office and ran a deficit of $1.4 trillion -- and that was during the worst recession since the 1930's, with much of it clearly cyclical. To run such a deficit near the peak of the business cycle is simply unprecedented.

Can the Republicans make up the difference by spending cuts? We always accuse them of wanting to "balance the budget on the backs of the poor." Can they actually do it? See the neighboring pie chart. Interest on the deficit cannot be touched without setting off a financial crisis. Republicans intend a major military buildup. Trump has vowed not to touch Social Security or Medicare (federal health insurance for the elderly). Medicaid, the federal health insurance for the elderly, makes up 9% of the federal budget and "income security," i.e., unemployment insurance, food stamps, disability payments and other programs for the poor make up 8% of the budget. Total spending on the poor: 17% of the federal budget. If one cut this amount to zero and kept everything else the same, it would balance the budget and even leave a small surplus. But under the Trump plan, which leaves fully 30% of the budget to be paid by borrowing, even zeroing these programs out would still leave a deficit about the size we have now.

Of course, Congressional Republicans may not be as crazy as Trump. As I understand it, they are currently proposing to ditch the infrastructure and enact a smaller tax cut. (I have not been able to find any specific estimates). So we may be spared deficits exceeding $1 trillion near the peak of the business cycle. But even a more modest increase in the deficit is unlikely to be sustainable because of the third distinction.

Primary versus fiscal deficit: The first table reveals something more than just the cyclical nature of deficits. It shows that we have regularly been running a structural deficit around 2.8% of GDP for the last 50 years. How have we managed to avoid fiscal crisis all this time? The answer is the distinction between primary and fiscal deficit. The primary deficit (or surplus) is the total deficit, minus payments on the national debt.

Why is that significant? It is significant because running deficits adds to the national debt and the amount of interest we have to pay on it. At the same time, we are constantly reducing the amount by paying on it. So long as deficits are equal to or less than interest paid on the debt, they can be sustained indefinitely. But if deficits exceed interest on the national debt, then gradually they add to interest paid on the national debt, and slowly interest payments eat up more and more of the budget and leave less and less for anything else. This is why running immense deficits cannot continue forever. Sooner or later interest payments will eat up more and more of the budget.

This makes interest rates immensely important. The higher interest rates, the sooner this phenomenon takes hold. In the 1980's interest rates were extremely high, both because of inflation and attempts to fight it. The spiking of deficits meant an immediate spiking of interest rate payments eating up the budget. Our ability to run protracted deficits was much less than we have now. But even now, with extremely low interest rates, extended deficits will catch up with us sooner or later. And if (as I suspect) Republican profligacy leads to higher interest rates, then our capacity for profligacy will diminish.

And that is the real reason that deficits on the scale Trump appears to be proposing will ultimately lead to serious problems.